Should you Refinance your ARM Before it Resets?

Most people choose adjustable-rate mortgages (ARMs) over fixed-rate loans because of their lower initial monthly payments. However, the rate and monthly payment of an ARM is eventually adjusted, or reset. For example, a 5/1 ARM resets after five years, and then annually after that. During periods of falling interest rates, the adjustments can be welcome. When rates are rising, however, you’ll have to brace yourself for higher monthly payments.

In order to help you determine whether you may benefit from refinancing, consider the following:

The rate caps on your mortgage

If you have an ARM that is about to reset, it’s crucial that you understand the caps on your loan. Caps are limits on the amount your interest rate (and, subsequently, your monthly payment) can go up. They are designed to protect you from the shock of extreme rate increases. There are three main types:

The initial cap limits the amount your rate can go up at the first adjustment period.

The periodic cap sets the maximum increase for any single adjustment.

The lifetime cap restricts the overall amount your interest rate can be raised over the entire mortgage term.

As an example, imagine that you have a 3/1 ARM with an initial rate of 4 percent. Your initial and periodic caps are both 2 percent, and the lifetime cap is 6 percent. Now let’s assume your mortgage will reset for the first time in one month, and interest rates have risen since you obtained your loan. If your new fully indexed rate were 6.5 percent, your initial cap would protect you, keeping your actual rate at just 6 percent.

Note, however, that your loan will be adjusted again a year from now, and even if interest rates stay the same, your ARM will go up to 6.5 percent, because an increase of 0.5 percent is still well under the periodic cap of 2 percent. As long as interest rates continue climbing, your mortgage rate will climb with it, by a maximum of 2 percent a year, until the lifetime cap halts the increase at 10 percent. That’s why caps may not provide long-term protection against rate increases.

Current interest rate trends

When rates appear to be rising over a long horizon, it may make sense to refinance your ARM before it resets, especially if you’re planning to stay in your home for several years. By locking in now for three, five or seven-or-more years, you can protect yourself from the possibility of steadily climbing rates.

Here’s an example. Assume you have an ARM with a principal of $200,000 and 25 years left on its term. Your current rate is just 4 percent, but it will reset in one year, and you expect the new rate will be 5.5 percent, rising to 6.5 percent the year after, and an additional 0.5 percent at each of the next two annual adjustments. Here’s how your monthly payments would look:

Current

In 1 year

In 2 years

In 3 years

In 4 years

Interest rate

4%

5.5%

6.5%

7%

7.5%

Monthly payment

$1,056

$1,222

$1,337

$1,394

$1,450

Now imagine refinancing your mortgage today, a full year before your current one resets. You opt for a 5/1 ARM with an initial rate of 5.75 percent, which will remain fixed for five years. This rate is much higher than your current one, and even more than the new rate you expect in one year. Your new monthly payment would be $1,258, considerably higher than the payments you’ll be making over the next 24 months. However, by the time you get to year three, your choice would be looking pretty good. And in four years, your monthly payment will be almost $200 less than it would have been with your old ARM. Over the first five years of your new mortgage, you will pay about $2,000 less interest.

The cost of refinancing

Of course, no one can predict for certain where interest rates will be headed next month, let alone four years from now. Rates may rise like in the example above, or they may decline, in which case you may see your ARM rate stay the same or even decline. Remember, too, that refinancing carries upfront costs that eat into your overall savings. In general, the longer you are planning to stay in your home, the more sense it makes to refinance now.

To help you determine what your new monthly payments are likely to be when your ARM resets, use the LendingTree adjustable rate mortgage payment calculator.